1.

CASE STUDY

Australian Motor Execs (AME) is set up as a proprietary companyand is considering whether to enter the discount rental car marketin Tasmania. This project would involve the purchase of 100 used,late model, mid-sized cars at the average price of $18,000. Inorder to reduce their insurance costs, AME will have a LoJackStolen Vehicle Recovery System installed in each car at a costof

$1,500 per vehicle. The rental car operation projected by AMEwill have two locations: one near Hobart airport and the other nearLaunceston airport. At each location, AME owns an abandoned lot andbuilding where it could store its vehicles. If AME does notundertake the project, the lots can be leased to an auto-repaircompany for $90,000 per year (total amount for both lots). The$25,000 annual maintenance cost (total for both lots) will be paidby AME whether the lots are leased or used for this project. Thisdiscount rental car business is expected to have minimum impact onAME’s regular car rental business in Tasmania, where the net cashflow is expected to fall by only

$20,000 per year.

For taxation purposes, the useful life of the cars is determinedto be five years and they will be depreciated using the mostadvantageous depreciation method set out by the Income TaxAssessment Act. It is assumed that the cars will first be used atthe beginning of the next financial year: 1 July 2018.

Before starting this new operation, AME will need to redevelopand renovate the buildings at each airport location. This isexpected to cost $220,000 for both locations. AME has alsobudgeted

$80,000 in marketing costs that will be spent prior the start ofoperation and during the first two years of operation. In addition,if the project is undertaken, a total new injection of $150,000 innet working capital will be required.

Maeve, the company CFO would like you help her examine theviability of the project for the next five years taking intoaccount the projections of sales and operating costs prepared byAME’s accountants. Given the risk associated with the project, shebelieves it is reasonable to use a cost of capital of 12% for theevaluation of this project. Further financial data relating to theproject can be found in the appendix.

*Question1. Discuss which costs are relevant for the evaluationof this project and which costs are not. Your discussion should bejustified by a valid argument and supported by references toappropriate sources.

APPENDIX: Additional information forthe case

Initial capital expenditure

Acquisition of the car fleet (including LowJack system): $18,000+ $1,500 per vehicle

Renovation of building at airport locations :$220,000

Injection of net Working capital $150,000

For tax purposes, the cars(including the LowJack system) may be depreciated using either theprime cost or the diminishing value methods as set out in Division40 of the Income tax Assessment Act (ITAA) 1997. The economic lifeof 5 years has been approved by the Commissioner of taxation. Maeveindicated to you that the company will retain the method that isthe most advantageous to the company from a financial point ofview.

Assume that AME is not able to claimany tax deduction for the capital expenditure relating to therenovation of the building until the business is sold. At that timethe cost of renovation is taken into account to calculate thecapital gain.

Marketing costs

The $80,000 marketing costs will beincurred as follows:

$40,000 immediately before the launch of the new operation(1/7/2018)

$20,000 at the beginning of year 2 (1/7/2019) i.e. end of year1

$20,000 at the beginning of Year 3 (1/7/2020) i.e. end of year2

These costs are fully taxdeductible in the year they are incurred (assume calendaryear).

Revenue projections

Revenue projections from car rentalfor the next five years are as follows

	Year 1	Year 2	Year 3	Year 4	Year 5
Beginning	1/7/2018	1/7/2019	1/7/2020	1/7/2021	1/7/2022
Ending	30/6/2019	30/6/2020	30/6/2021	30/6/2022	30/6/2023
Revenue ($’000)	900	1,100	1,200	1,250	1,250

Operating costs

Operating variablecosts associated with the new business represent 10 % ofrevenue. Annual operating fixed costs (excluding depreciation) are$1800 per vehicle.

Existing administrative costs are$550,000 per annum. As a result of the new operation theseadministrative cost will increase by 20 %.

Tax rate

The company is subject to a tax rateof 27.5% on its profits. The capital gain (if any ) on the sale ofthe business would also be taxed at 27.5%.